Wednesday, September 01, 2010

The actual effects of inflation

Via Matthew Yglesias, Josh Barro makes the case for indexing capital gains taxes:
But one likely barrier to a higher inflation target is a quirk of tax policy: non-indexation of capital taxation means that higher inflation causes a stealth rise in the real tax rate on capital gains and interest income...

Inflation has large impacts on the real capital gains tax rate. To understand why, consider an investor who buys an asset for $100 and earns a 40% real gain over seven years. In a world of 2% inflation, the investor’s nominal gain is $60.82, and he pays $9.12 in capital gains tax at a 15% nominal rate; this is a 19.9% effective tax rate on his real gain of $45.95 (equivalent to $40 at the start of the investment period).

But if the inflation rate had been 4%, the nominal gain would have grown to $84.23 and the real tax rate to 24.0% -- a 21% relative increase in the tax rate. This effect would be even larger if the real rate of return were lower, meaning the inflation penalty on capital gains grows when inflation is high or when asset markets are anemic.
I'm glad to see Josh Barro addressing this issue: although it's little understood, it's arguably the most important economic effect of inflation.

To see why, it's useful to look at the more commonly cited deleterious effects of inflation. These include:
  1. It hurts people on fixed incomes.
  2. More generally, it redistributes from lenders to borrowers.
  3. It lessens the incentive to save.
  4. It causes people to hold an inefficiently low level of real money balances.
  5. Adjusting prices incurs a transactions cost—for instance, in updating a menu.
Upon closer examination, none of these except the last two are really problematic effects of "inflation." Rather, they arise from unexpected and variable inflation. If high inflation is expected, it will be built into pension plans and interest rates; assuming it stays on target, no economic damage is done. Of course, if inflation moves in an unanticipated direction, we see an arbitrary redistribution from lenders to borrowers (or vice versa), and the resulting uncertainty will lessen the incentive to save. But the damage here is from the unexpected component of inflation, not inflation itself.

The direct effect of inflation on money balances is also quite small. 4% inflation won't cause any serious inefficiency in the use of cash for transactions; we carry so little actual cash that the small amount eroded by inflation is almost irrelevant, and when we pay via checking accounts inflation only matters for the fraction of our deposits that banks keep as reserves. (The required reserves ratio is at most 10% in the US for demand deposits and zero for certificates of deposit, money market funds, etc.) Moreover, inflation has no clear impact on the real returns to investment: the future nominal returns from an equity investment scale up along with inflation, with zero net real effect. And most firms change prices often enough that a moderate level of inflation doesn't lead to any serious logistical inconvenience.

To sum up: the commonly cited downsides of inflation are not really problems with inflation at all, but rather a lack of precision in our expectations of inflation.* Other negative effects are close to zero in practical terms, at least when we restrict ourselves to inflation levels that are plausible in the United States. So what is so bad about inflation—assuming it doesn't unpredictably lurch around?

As far as I can tell, interaction with capital gains taxes is actually the key issue here. Starting in the late 1970s, Martin Feldstein convincingly argued that the era's high inflation imposed an extraordinary burden on capital investment—which, of course, is critical for economic growth. This wasn't because inflation was inherently problematic. It was simply a result of the distortions imposed by a tax system that failed to index properly.

Given the central role of inflation in discussing macroeconomic policy, it is astonishing that this effect is so little understood by the commentariat.

*As Arnold Kling points out, the distinction blurs a little if high inflation itself causes expectations to be less accurate.

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